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Private equity insider

Private equity firms have been making quite a splash in the multichannel marketing industry in recent years. Each month seems to bring news of at least one major private-equity transaction.

So what’s the deal on landing a PE deal?

Private-equity investment funds acquire businesses, support management teams with strategic resources, and grow those companies for a later sale in hopes of a big financial return. Private equity has grown substantially in recent years and continues to invest — and divest — at a rapid pace.

Direct marketing has been a recurring favorite industry of the PE community, and 2007 was no exception. In all, 2007 saw 79 multichannel/direct marketing transactions involving PE firms.

Why do PE firms like direct marketers? The industry is highly fragmented, with an estimated 10,000 to 15,000 catalog titles alone, offering a deep pool of potential acquisition targets and consolidation opportunities.

Additionally, direct marketers have not relied exclusively on large investments in stores and have low receivables, resulting in unusually high cash flows. This allows PE firms to realize higher returns on total capital and effectively use their favorite financial engineering tool, debt, to further enhance returns.

Finally, the growth offered by the expansion of Internet shopping and procurement is a structural change facilitating rapid growth.

Many owners of multichannel businesses have partnered with PE funds to finance a substantial liquidity event to secure their personal wealth, while staying involved as both CEO and investor to grow their businesses. Bringing in a quality PE partner can have many benefits for a business owner, including:

Taking substantial cash out of the business and diversifying one’s personal wealth;

Remaining in place to manage the business, with management succession assistance from the PE fund;

The opportunity for the owner to reinvest a portion of his proceeds for a “second bite of the apple” when the PE fund exits the investment — usually at a substantial profit;

A financial partner with industry experience, relationships, and strategic insight; and

Support and financing for rapid growth through acquisitions of smaller direct marketers to add new products and customers.

THE INVESTMENT CYCLE

Once a PE fund is established, it begins a period of acquiring businesses, with the hope of exiting those investments within a specified period (usually two to five years). It also aims to secure equity returns of 20% to 30% for its investors.

The “exit” may be achieved through a sale of the business to either a larger operating company (a “strategic buyer”) or another PE fund, or by taking the target company public. A high return on investment drives compensation to the PE fund professionals and the PE fund’s ability to raise a new fund.

PE funds typically finance their acquisitions through a combination of equity and debt capital. While equity is usually 35% to 40% of the capital structure, the exact ratio of equity to debt will vary depending on the stability of the company’s cash flows. PE firms typically strive to use high levels of debt to enhance return on investment.

To ensure that these high levels of debt are serviceable by the company, PE funds focus on businesses that have strong, stable cash flows, low capital expenditure requirements, and substantial growth prospects.

For these reasons, direct marketing businesses with defendable market niches, low overhead requirements, and scalable business models tend to be popular investments and attract substantial enterprise values.

How does the sale process work? The typical time frame for an acquisition by a PE fund is approximately six months, and involves several key steps:

Investment banking representative

Most business owners achieve maximum value by involving a knowledgeable investment bank with relevant experience in the direct marketing and retail industry. An effective investment banker will take the time to understand the needs of the business owner, identify and communicate with buyers, and run a smooth auction for the business. The best process will promote competition among bidders to achieve maximum value and the most favorable terms.

Positioning the company

The investment bank will work with company management to create a detailed overview of the business. It will also create an investment thesis in the form of an offering memorandum that will effectively communicate the company’s story and the opportunity to potential buyers.

In addition to the company’s financial results, buyers will focus on the health of the 12-month customer list, customer retention, growth opportunities and the economics of prospecting, and trends in merchandising and marketing.

Contact and communicate with the PE funds

The company’s investment banker will know the investor and strategic buyer universe that has strong interest in the direct marketing space. The investment banker must effectively communicate the company’s story and its growth potential in conversations with potential buyers. Interested buyers will be asked to provide indications of value before being asked to move forward in the process.

Meet with interested buyers

The company’s owner and management team will present an overview of the business during face to face meetings with a narrow group of potential buyers. The management presentation is a forum to further interest the potential PE buyers and give them a feel for interpersonal compatibility.

Due diligence and bidding

Interested PE firms and strategic buyers will begin their “due diligence” investigation in earnest, seeking to understand every detail of the business. Buyers will then submit firm bids for the company, with detailed proposals for purchase price, capital structure, and legal terms.

Valuation

The PE fund valuation will be affected by many factors and is determined using a range of methods. The most often utilized factor is the company’s historical and future cash flows, using EBITDA (earnings before interest, taxes, depreciation and amortization) as a proxy.

Other key factors include the company’s working capital and capital expenditure requirements. It is common (though somewhat oversimplified) to think about value as a multiple of the company’s last 12 months’ (LTM) EBITDA.

Business valuations commonly range from five times to 10 times LTM EBITDA, with the multiple reflecting the size of the business, the quality and consistency of the target’s earnings, growth, and the macro economic cycle.

For example, a five times multiple of LTM EBITDA would typically indicate flat growth and inconsistent performance. A 10-times multiple reflects superb annual sales growth over 15% to 20%, strong earnings growth, consistent and predictable revenues, EBITDA over $10 million, and an attractive economic growth story and healthy industry.

Reinvestment

Most PE funds will want the owners or sellers to reinvest between 10% to 30% of their proceeds in the business. The PE fund wants the seller to retain some “skin in the game” to keep his focus on building the business.

This can be an especially exciting part of a private equity transaction, because the seller can invest very few dollars in the transaction without any personal recourse for the incurred debt. And the seller can achieve a second substantial liquidity event when the PE firm exits the investment.

Negotiating the transaction

A well-managed process will yield unexpectedly broad valuation ranges in the buyer bids. The business owner and investment banker will negotiate the best possible combination of price and terms and ultimately select a buyer with whom to work exclusively. Critical issues include certainty and speed of closing (how confident are the sellers and the seller’s investment banker that the PE fund can actually close the deal, and do so expeditiously?), form of consideration (cash is king), and reinvestment terms for the seller.

The indemnification terms are another factor. Indemnification is the buyer’s recourse for compensation if the seller has made inaccurate promises in its contractual “representations and warranties” in the purchase agreement. Typically, there would be a negotiated “cap” on the seller’s indemnities, far below the purchase price, along with a “basket” that defines an amount that the buyer is obligated to incur prior to securing recourse from the seller.

Upon the close of the transaction, the seller must deliver to the buyer a “normal” level of working capital. A working capital adjustment mechanism built into the purchase agreement compensates for the impact of seasonality or other peaks and troughs of working capital. It also prevents the seller from “gaming the system” by delaying payables and accelerating receivables prior to closing.

Final due diligence, documentation, and closing

This stage involves careful coordination among the target’s management team, investment banker and legal team to hammer out all the detailed terms and documents. The PE fund will simultaneously be completing documentation of its debt package with the lenders.

SIZING UP A PE PARTNER

A business owner should approach the potential transaction by doing as much due diligence on the interested PE funds as those funds will do on his business. Consider these three key factors when evaluating a PE partner:

Chemistry

Most PE funds are involved at the board of directors level, while some plan a more “hands-on” role. If the business owner is going to remain CEO of the company after the transaction, he should understand how the PE fund plans to operate and attempt to partner with PE professionals with whom he has genuine rapport.

Finding a value-added partner

Are the PE fund’s professionals more than just financial engineers? Does the PE fund have experience with multichannel and direct marketing businesses? Can they help with new ideas in Internet marketing, name acquisition, or new promotional channels? Does the fund have the strategic expertise and industry relationships to place valuable directors on the board? Will the PE fund support acquisitions to grow the business? What is the PE fund’s exit strategy and what is their time horizon?

Track record of success

The PE fund should be able to show substantive realized returns on its prior investments to warrant consideration. Have previous sellers/CEOs been happy with the relationship?

References from other business owners in the PE fund’s portfolio are invaluable to understanding how the PE fund interacts with its portfolio companies and management teams. Pay particular attention to references from previous sellers who have already exited, who no longer have any reason to withhold potentially difficult perspectives.

In determining if a private equity investor is right for a business, the owner should consider his or her personal life situation and time horizon to determine if a PE investor is the best solution. Is the business owner at a stage in life where asset diversification has become a priority? Is the owner/CEO willing and able to continue in that role for several more years after a transaction, and willing to function in an environment where control has been ceded to the PE fund? Is there a growth scenario for the company that could benefit from an influx of capital and strategic guidance to allow the business to expand?

PREPARING FOR A SALE TO A PRIVATE EQUITY BUYER

A multichannel business owner should proactively prepare several years in advance for a potential transaction to make the company as attractive as possible. Building a first class management team and fine-tuning the business model now will drive significant value during a sale process.

Fine-tune the business model

PE firms like direct marketing businesses that have growth in multiple selling channels — be it catalog, Internet, stores, magazine advertising, and/or DRTV/radio — because channel diversification usually reduces business risk. Business owners should strengthen their marketing and merchandising organizations based on a tightly developed understanding of variable costs and marketing contribution.

Aggressively continue customer acquisition subject to rational objectives, such as six-month breakeven on the worst performing segments. An intense focus on execution several years in advance of a sale process will optimize value in a transaction.

Round out an effective management team

PE funds are less excited by a “one man show,” or a business run by a dominant CEO/owner. The rationale is simple: If the owner loses focus after monetizing his wealth or dies, who will step in to run the company? Develop a succession plan and a well-rounded management team with powerful executives who understand their roles and the company’s strategic vision. If you’ve been debating internal changes, don’t wait any longer! The time is now. A sophisticated CFO who is comfortable operating in a leveraged environment will further enhance the company’s appeal.

Institute proper controls

The one- or two-year period prior to beginning the sale process is the time to ensure that the company’s financial reporting is appropriately managed. PE funds will dissect every aspect of the company’s financial statements, and the quality of accounting must be of the highest order. The seller should complete annual audits and develop strong internal financial controls, both of which will pay significant dividends during a sale process and make the transaction smoother for the seller.

Sophisticated PE funds understand the value of the multichannel model, and many funds are solely focused on acquiring businesses in this industry. A savvy PE fund can provide owners with unique strategic and financial assistance to build their businesses and help them implement succession plans.

A business owner who understands and appreciates the private equity model — and is committed to running a tightly orchestrated sale process — will be rewarded with significant liquidity. Not to mention a substantial and tasty “second bite at the apple” down the road.

David Solomon is co-CEO of Lazard Middle Market (www.lazardmm.com), a New York-based investment bank.

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